Wholesalers, however, will benefit significantly from this wave since a majority of their profits come from generic drugs.

In this article, I describe a simple metric—Operating Profit as a Percentage of Gross Profit—that highlights wholesalers' changing financial economics. For each company, I illustrate this metric for 2008, 2011, and 2014 (projected).

So, the next time a wholesale executive whines about “low profit margins,” you can whip out this article for a more fact-based discussion.IGNORE GROSS MARGIN

Gross profit equals the revenues received by a wholesaler minus the costs of products (net of discounts and returns) bought from a manufacturer or another wholesaler. Gross profit measures the portion of revenues available for the operating expenses and operating profit of a wholesaler. It reflects how much a wholesaler is “paid” for taking on specific tasks and functions in the distribution system on behalf of customers and/or manufacturers.

Gross margin expresses gross profit as a percentage of revenues. We estimate that the industry-wide gross margin from core drug distribution was approximately 3.2% in 2011. Pharmaceutical wholesaling has very low gross margins compared with other wholesale distribution industries.

Using gross margin, overall profitability of pharmaceutical wholesalers appears very low when compared with revenues, i.e., three cents on the dollar.

But don’t be fooled. This traditional financial metric mask the underlying—and growing—profitability of the drug wholesaling business.

The chart below shows EBIT as a percentage of Gross Profit (rather than revenues) during the past three years. The ratio has been increasing for each of the Big Three wholesalers, demonstrating their ability to retain more gross profit dollars by decreasing operating expenses and increasing gross profits from generic drugs. AmerisourceBergen and McKesson convert almost half of all gross profits into operating profits.

For a wholesaler, generic drugs yield more gross profit dollars per unit than brand-name drugs. As a result, wholesalers have the rare good fortune of simultaneously increasing gross profits while retaining a greater share as operating profits.

Exhibit 25 in my 2011-12 wholesaler report illustrates the financial interplay among revenues, gross profits, operating expenses, and operating profit using data from AmerisourceBergen. For instance, ABC has gross profits of about $2.5 billion in 2011, up from $2.0 billion in 2008. During this same period, the EBIT/GP metric increased from 40% to 48%. Very nice!

This metric also demonstrates how very small percentages translate into large dollar amounts. A one basis-point increase in EBIT margins for a company with $80 billion in revenues translates into an additional $8 million of operating profit. A 30-basis point increase equals $240 million in additional profit dollars.

A risk to this forecast is growing pressure on pharmacy profits from generics. More on that topic another time.

AND DON’T FORGET ABOUT ROIC

Return on Invested Capital (ROIC) is one of the most effective single measures of wholesaler profitability. ROIC measures a wholesaler’s efficiency at generating a return relative to the capital invested in its business. It includes both the cost of the assets employed as well as the cost to acquire those assets. Thus, it is a useful measure for illustrating the interplay between income statement measures and the balance sheet.

Here’s how the generic wave will boost ROIC for wholesalers:

Wholesalers retain only about 40% of the product volume once a product goes generic, because large self-warehousing customers no longer purchase through the wholesale channel. These customers have lower EBIT margins for wholesalers. Thus, a wholesaler’s average EBIT margin will increase despite the reduction of volume.

As the chart above projects, the generic wave will increase EBIT dollars by reducing the share of gross profit absorbed by operating expenses. Dollar increases in EBIT will improve Return on Invested Capital (ROIC) because EBIT appears in the numerator of the ROIC computation.

The generic wave will decrease invested capital, the denominator of the ROIC computation. Since wholesalers purchase generic drugs at large discounts vs. brand-name drugs, the value of product inventory on a wholesaler’s balance sheet also declines for a given level of prescription volume.

BTW, ROIC is much harder to fudge than an income statement metric such as Earnings per Share (EPS). Until this year, McKesson used EPS as the “primary performance metric” for short-term and long-term executive compensation. AmerisourceBergen relies more heavily on ROIC. Guess which CEO made more money? (Sorry, Steve.)

1 comment:

Why don't wholesalers just report their margins by brand, specialty, and generics? The argument about low margins would be credible if they could prove that the margins are fairly consistent. After all, does the wholesale distribution cost of a 1,000 count bottle of Lipitor radically change when it goes generic?

DISCLAIMERThe analyses on this website are based on information and data that are in the public domain. Any conclusions, findings, opinions, or recommendations are based on our own experienced and professional judgment and interpretations given the information available. While all information is believed to be reliable at the time of writing, the information provided here is for reference use only and does not constitute the rendering of legal, financial, commercial, or other professional advice by Pembroke Consulting, Inc., Drug Channels Institute, or the author. Any reliance upon the information is at your own risk, and Pembroke Consulting, Inc., Drug Channels Institute, and the author shall not be responsible for any liability arising from or related to the use or accuracy of the information in any way. Pembroke Consulting, Inc., and Drug Channels Institute do not make investment recommendations, on this website or otherwise. Nothing on this website should be interpreted as an opinion by Pembroke Consulting, Inc., Drug Channels Institute, or the author on the investment prospects of specific companies.

The comments contained on this site come from members of the public and do not necessarily reflect the views of Drug Channels Institute or the author. Neither Drug Channels Institute nor the author endorse or approve of their content. Drug Channels Institute and the author reserve the right to remove or block comments, but are under no obligation to explain individual moderation decisions.

The public domain use of our materials includes linking to our website. You do not need to obtain special permission to link to the Drug Channels site. The material on this site is protected by copyright law. Unauthorized reproduction or distribution of this material may result in severe civil and criminal penalties and will be prosecuted to the maximum extent of the law. This report may be cited in commercial documents with full and appropriate attribution. We do not intend to reduce, limit, or restrict any rights arising from fair use under copyright law or other applicable laws. We do not permit our articles to be republished without prior written permission.

The content of Sponsored Posts does not necessarily reflect the views of Pembroke Consulting, Inc., Drug Channels Institute, or any of its employees.